Illinois Pension Bonds to Test Investors’ Faith

The first time Illinois tried to bail out its teetering pension fund by borrowing billions of dollars, it ended in disaster.

Nevertheless, the state is trying again.

Illinois hopes to sell $3.7 billion of bonds to make this year’s contribution to its fund. It is essentially paying a single year’s bill by adding to its already heavy debt load. That short-term thinking is not unlike Americans taking out home equity loans to pay for cars and vacations before the housing bust.

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Governor Pat Quinn of

But investors have learned a lot about the pitfalls of debt since the state tried to shore up its fund a few years ago. This time the municipal bond markets are jittery, and federal securities regulators are investigating whether Illinois has been properly describing its pension fund and the risks it may pose.

Amid the heightened oversight, Illinois is providing more information about its troubled finances than in the past. So much unfavorable detail is emerging that the bond issue will test investor faith in a deeply troubled state’s commitment to do whatever is necessary, raise taxes or cut services, to keep its promises to bondholders.

Illinois was initially scheduled to sell the bonds on Thursday. But on Monday, the sale was pushed back until next week, state officials said, so the bond markets, and overseas investors, would have more time to digest Gov. Pat Quinn’s budget address on Wednesday.

In his budget address, Mr. Quinn praised what he called “the most far-reaching public pension reform in our nation’s history,” a law passed last year sharply reducing the pensions of state workers to be hired in the future and cutting the state’s yearly pension contributions for the next few years. Some actuaries who have studied the documents have expressed strong reservations, saying the new contribution schedule is not based on any accepted actuarial methodology and puts the pension system at risk.

More warnings appear in the fine print of the governor’s budget proposal, also issued on Wednesday. Despite last year’s reform, it said the pension system is still so weak that the state may have to seek “a federal guarantee of the debt” — presumably the kind of intervention that many Republicans in Congress have been warning they will oppose.

“While the pension reform of 2010 improved the situation,” the document stated, more fixes are still needed. It suggested further benefit cuts, more bond sales, bigger contributions from the state or federal intervention. “Until one or more of these options is achieved, pension funding issues will persist.”

These grim revelations show the dilemma facing Mr. Quinn, who is balancing the state’s budget in part with a big income tax increase and trying to address the pension imbalance without cutting current workers’ benefits. With the S.E.C. watching closely, the state cannot play down its distress without risking accusations of securities fraud, like the complaint the commission filed against New Jersey last year. But if it paints too dire a fiscal picture, investors eyeing its bonds next week will demand a higher rate of interest.

John Sinsheimer, the Illinois director of capital markets, said he did not expect a problem.

“From what I’m hearing from our banks, the market is quite interested in this issue,” he said in a telephone interview.

And credit analysts said they believed that the bonds would offer an attractive premium, even though the actual risk of a default was negligible. Guy Davidson, director of municipal investments at AllianceBernstein, said similar single-A rated bonds were trading about 2.3 percentage points higher than triple-A rated bonds.

“Given the size of the deal, our traders would expect Illinois’s pension bonds to come in at higher yields,” he said, “but would expect enough demand to place all of the deal.”

Illinois’s first attempt to shore up its pension fund with a record-breaking $10 billion bond sale has long been criticized, not least because it led to the indictment of former Gov. Rod Blagojevich and several associates on influence-peddling charges. It was pitched at the time as a creative way to strengthen both the state and its pension fund, by allowing Illinois to borrow at low interest rates, then cover the borrowing cost by investing the proceeds at a projected 8 percent rate of return in its pension fund.

The strategy failed because the pension investments have so far paid a lower rate of return, roughly 3 percent, than the interest rate on the bonds, about 5.1 percent.

“The dynamic is horrific here,” said Robert G. Smith, president of Sage Advisory Services, an investment firm in Austin, Tex., who said he generally avoided bonds sold to replenish pension funds because they could backfire this way.

Mr. Sinsheimer said that with the current bonds, Illinois was making no attempt to bet on interest rates or investment returns.

Don't be passive

“The bonds we’re talking about issuing next week are not meant to do what the 2003 bonds did, so the rate of return the portfolio of the pension funds earn is not relevant to this discussion,” he said in a telephone interview. Rather than seek high returns, he said, “the pension bonds we’re issuing next week are simply for this year’s contribution.”

“Governor Quinn believes that we need to make these payments,” he said. “We are financing these payments by borrowing. Period. There is no attempt at arbitrage.”

Illinois has a team of banks, actuaries, lawyers and financial advisers helping it get the latest pension bonds to market. The lead underwriters are Morgan Stanley , Goldman Sachs and Loop Capital Markets; 11 other underwriters will sell smaller portions. A local firm, Peralta Garcia Solutions, is advising the state, and three law firms are helping make sure the bonds are issued legally.

The underwriters will be paid out of proceeds from the sale, so they have a strong incentive to get it done, but not to question whether it is a good idea for Illinois in the first place.

The bond prospectus offers an unusually detailed history of how Illinois’s pension system came to be so strained. It describes not only the state’s losing bet on interest rates in 2003, but an unusual feature: Those bonds called for the state to reduce its annual contributions to the pension fund, and use the money instead to pay the bondholders their interest.

Those diversions, plus enormous investment losses in 2008 and 2009, have left the pension fund with a shortfall of about $86 billion, the prospectus explains, roughly twice the shortfall before the 2003 bonds were issued.

“When I read this, quite frankly, it made me ill to my stomach, because that pension plan has been consistently abused now for at least the last 16 or 17 years,” said Brad M. Smith, president-elect of the Society of Actuaries, which is based in Illinois.

Mr. Smith, who was speaking on his own behalf, is also chairman of Milliman, a large actuarial firm. He called the state’s schedule of pension contributions for the coming years “incredibly dangerous,” adding: “There’s a reasonable chance that these plans will run out of money.”

He said one of the main problems was a state law, passed in 1994, permitting Illinois to contribute less to the pension fund every year than the amount that would actually cover the benefits. Adding new bond proceeds will not address that basic flaw.

The prospectus states that Illinois calculates its statutory pension contributions each year according to an accepted actuarial method. In recent months, however, outside actuaries have reviewed the calculations and argued that Illinois’s method is not one of the permitted ones. They say that when Illinois enacted its 1994 pension law, it erred, a problem that has escaped detection until now.

Actuaries that work for states are coming under more scrutiny. In October, an official from the S.E.C.’s special task force for public finance gave a tough talk at the annual meeting of the Conference of Consulting Actuaries.

“Don’t be passive if you are aware of inaccurate statements or questionable practices, particularly to conceal or distort your actuarial analysis,” said Peter K. M. Chan of the S.E.C.’s Chicago office. He described recent cases where the commission had found actuarial numbers being used to mislead municipal bond investors about the health of public pension funds.

“It’s a warning,” said John M. McNally, a partner at the law firm Hawkins, Delafield & Wood, who is helping the city of San Diego with its financial disclosures after a pension fund scandal there.

The commission sued several city officials, but not the actuary, in the San Diego case. Mr. McNally said the S.E.C. now seemed to be putting actuaries on notice that they, too, could be liable under federal securities law for aiding and abetting fraud.